Friday, December 5, 2008

This chart has data through December 3rd, and things are still looking good. Nonfinancial corporations are still able to access the commercial paper market, and the amount outstanding continues to rise, as it has for the past five years. Same story for Commercial and Industrial Loans.

12 comments:

Do you know of any good books on free banking and/or monatary policy or Federal Reserve reform?

We've heard a lot about how the Federal Reserve's low interest rate policy during the beginning of the decade helped fuel the housing bubble (although Fannie and Freddie probably contributed more).

Here's a thought. What if the federal government were unable to issue debt? The only way it could finance a budget deficit, more government spending than revenues, would be through monatizing the difference between these two.

It sounds radical. But it seems that one reason why the budget deficit and the national debt are abstractions whereas social programs and taxes are real is because the Federal Reserve, by issuing debt, prevents the public from feeling the impact of deficit spending.

If inflation skyrocketed during a period of deficit spending, the public would have to decide if price increases were a reasonable price to pay for the increased spending or reduced tax revenue.

Maybe there would be more pressure on politicians to stop bailing out every business that appears before the Senate Banking Committee and asks for 37 billion?

Maybe I've been watching financial shows for too long. But it seems that the politicians are putting the entire economy on welfare and no one holds them accountable for their actions. Meanwhile our debt to GDP ratio is closing in on France's.

I've been pretty critical of Fed policy for a long time. I think Greenspan made some huge mistakes beginning in the late 1990s when he tightened too much, then in 2002-2004 when he eased too much. Bernanke has made huge mistakes as well. Bad monetary policy has really messed things up, and not many people understand this, which is another problem. I don't know of anyone who has come up with a better solution than a return to a gold standard or some variation on a gold/commodity basket standard. We've got to somehow get rid of the "discretion" in today's discretionary monetary policy.

I think there is a good case to be made for not doing what you suggest regarding deficit financing. I wrote a paper for a Cato monetary conference some years ago in which I argued that our federal debt serves a valuable function and we should always have a liquid Treasury market (which should be at least 20% of GDP by my reckoning), since it makes financial markets much more efficient. You've got to have risk-free securities as a reference point. Running a surplus and shrinking the Treasury market is not necessarily a good thing at all.

Debt and deficits have never really been a problem in the US, but it might become problematic in the future. Total debt/GDP ratios like today's 50% are not a problem at for a dynamic economy like ours. Even 75% would be OK. The problem is too much government spending since it is so inefficient. It slows progress.

Inflation is a terrible thing that should be avoided at all costs. Price stability should be paramount. Then we need to fight constantly for limited government. If we fix those things, everything else is easy.

I sure agree that the gold standard is probably the only device that has ever reigned in government manipulation of the money supply. To avoid the boom/bust cycle, though, we would also have to change our banking practices.

The fractional reserve banking system is a key source of economic instability, according to the Austrian School theories. This is especially true when the central bank orchestrates very low reserve requirements and then bails out banks with solvency trouble. These policies endorse reckless lending behavior and allow tremendously excessive credit expansions.

When bank lending is in excess of savings, it constitutes an increase in the money supply. Here is a sentence from F.A. Hayek that gets to the heart of why this is a problem: "The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labor and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate — or perhaps even only so long as it continues to accelerate at a given rate."

Joe: Thanks! As for your question, I'm not sure I can answer it. I do remember that 2003 marked the tail end of the great corporate deleveraging which began in 2001, and it was also a time when the economy was booming. The Fed was targeting a 1% funds rate at the time, and had announced its intention to keep rates low for an extended period. Perhaps the prospect of very low (way too low as we now know) interest rates convinced companies to start borrowing again, which would account for the sharp upturn in CP issuance. I would also suspect that some changes in the tax code were responsible for the late 2003 plunge, but I can't put my finger on anything. Maybe other readers can help?

Tom: I think it will be a long time before banks engage in reckless lending practices, unless, of course, the government mandates it.

I would take issue (again) with your implicit assertion that banks created too much money because of fractional reserve banking. With the Fed's targeting of the interest rate on reserves, the Fed has control over how much money the banking system can create. If we ended up with too much money, it was entirely the fault of the Fed (for picking the wrong rate), and not the fault of the way the banking system is structured.

Since the money supply is growing in a reasonable trend yet the economy is shrinking, doesn't that indicate the slowdown is coming from a reduction in the velocity of money? If that's the case, what will it take to reverse the shrinking velocity?

It seems that the velocity has been historically high over the past decade or two due to financial innovation (ie. securitization, shadow banking, carry trade, etc.), but now such innovation has not only stopped, but past innovations have disappeared. Given that fact, can we expect the velocity to go back up in the foreseeable future?

Mark: velocity has declined of late as you note. I measure velocity by dividing nominal GDP by M2. The inverse of velocity is money demand, and sometimes it's easier to think in those terms.

Velocity has fallen and money demand has risen in the current crisis. It's easy to see that people want more money because they fear all sorts of things these days. So money demand is up because of the desire for safety. Once people's confidence is restored, it's reasonable to assume that money demand will drop and velocity will increase.

M2 velocity has been slowly but erratically rising ever since the early 1970s and I see no reason why that major trend will disappear.

A friend of mine emailed me the following after reading my email to him with of your "No shortage of money (4)." You thoughts?

"I have major developer friends who have run major real estate development firms on both east/west coasts. All attempts to secure loans for the past 6-months have been in vain. These are companies with 20+ years history of success after success. Scott Grannis may be a smart guy and have data that says otherwise, but guess what, no one is lending, even to the good guys."

Hope you don't mind me throwing up a thought, and I hope, too, that Scott doesn't mind me cluttering up his blog with another so-called Austrian idea.

Consider, however, how the Austrian Business Cycle Theory explains both of these observations. The Theory says that the credit expansion and artificially low interest rates cause too many projects to be started -- more than can be supported by the finite resources available.

As long as the credit expansion grows exponentially, everybody continues to plug ahead, bidding resources away from each other with their newly minted money. As soon as credit can no longer grow exponentially, however, many entrepreneurs discover that their projects cannot continue.

The expected result is exactly what we now see: record amounts of credit extended -- but not "enough." The solution, obviously, is not a further expansion of credit, because that will not solve the underlying problem.

I would add that maybe builders are finding it especially difficult to compete for the now inadequate credit supply because lenders are over committed to that sector -- and because it is now obvious that both residential and commercial real estate has been overbuilt?

CDLIC: I think Tom may be right, that some lenders are trying to reduce their exposure to the real estate sector in general. Plus, there is a widespread fear that commercial real estate is going down; witness the destruction in the CMBS sector in the past month. There is a big rotation going on in the economy, away from real estate and towards other areas that are growing, such as exports and alternative energy and green-related industries. So in aggregate credit is abundant, but in certain specific areas it is scarce.

I'm aware of at least one real estate developer/builder (land and houses) that has bank Line of Credits in place for all of 2009. However there are factors within the LOCs that will effectively prohibit any new projects until current inventory reaches a healthier level. So there has to be a take-up of existing houses before anything new can get off the drawing board. In fact there isn't much new on the drawing board. Long-term survivorship is in the bank's hands. That is, if the market remains at today's levels for a year, the existing inventory will have age enough to cause covenant violations, giving the banks the right to call the loans. Even if there is currently pent-up demand building and the market returns to some type of normalcy .... it will be tricky to have the right product available when that happens.